Hoard capital, curb risk and diversify: a covid-19 survival guide

The below article appeared in the May 12th edition of The Australian. Peter Warnes' commentary is exclusively available to Morningstar Premium subscribers and trialists. Take a free 4 week trial to Morningstar Premium.

The sheer breadth and depth of the disruption caused by coronavirus to the global economy and the behavioural patterns of society at large have been a real, and perhaps overdue, wake-up call. Hopefully, selfishness and greed will make way for more compassion and sharing, together with increased recognition of the effects of isolation that many currently encounter as a part of normal daily life.

The virus has ruptured global supply chains and exposed the overdependence on China. There will be many changes and globalisation, even capitalism may ultimately suffer. Things we have taken for granted are now being questioned. Perhaps it is also the appropriate time for investors, particularly those transitioning to retirement or those already in pension mode, to review their portfolios from a dependence viewpoint.

Ensure your portfolio is diversified and not isolated or too exposed to any one country, sector or thematic. Similarly, in these uncertain times, make sure your fund’s objectives and strategy are aligned. Perhaps it’s time to rethink that low maintenance “set and forget” strategy.

Risk-adjusted returns are key, so don’t chase yield. With income streams under pressure, it becomes increasingly important to protect capital and reduce risk profiles. It’s better to dip into capital temporarily rather than entertain higher-yielding riskier returns. Liquidity is also paramount. To be on the safe side, consider access to at least one year’s expenses either within the portfolio or outside it, without the need to sell assets. Minimise exposure to unlisted assets. Direct investment in property is not a liquid asset.

Transitioning to or being in retirement does not mean investors should shun growth for income. While the composition of the portfolio may take on a greater income bias, it is also critical for the capital base to grow on a risk-adjusted basis as time in retirement could, and hopefully will be, measured in decades not a few years. Think about prudently buying “green bananas”! Perhaps look at select exchange-traded funds with a growth-bias toward technology, cyber security, healthcare and pharmaceuticals or a successful global fund manager with a strong performance record, like Magellan Financial Group (ASX: MFG)—exposure to the fund manager.

In the near to medium term, shareholder returns are likely to be lower than those of the past five years. The timing for those transitioning to retirement is somewhat unfortunate. Those transitioning should wait for a market recovery before switching from a market-linked structure to gain some exposure to annuities. Income sources are drying up, which is of increasing concern to the retiree cohort. Returns on cash and term deposits are low and unlikely to improve for several years and dividends overall will be cut by billions in 2020 and 2021, from 2019’s elevated levels.

Emphasis should be on the sustainability of free cash flow. Morningstar’s economic moat methodology is predicated on a company’s sustainable competitive advantage that will deliver excess returns over the cost of capital and allow shareholders to share in the rewards.

The banking sector, that great source of fully franked dividends, will struggle over the next year or so, but should return as the economic recovery gains traction. The banks are bankers to the economy and earnings and dividends are sensitive to its overall health and normalised loan impairments. While income is important, understand hybrids are not an alternative to term deposits. They sit one step above equity in a bank’s capital structure and therefore have quasi-equity risk. And they are much less liquid, so prices can be more volatile.

Reliable sources of income over the next few years should include supermarkets, hardware and home improvement, telecommunications and some utilities. Changes in behavioural patterns and the way we work are likely to impact the rental income of retail and office-focused REITs. Depending on the level of geopolitical backlash from coronavirus, China-facing companies may well see an interruption in historical demand patterns. Discretionary spending is likely to struggle for some time as the consumer focuses on increased savings and deleveraging, many after a near-death experience.

As the Australian government looks in earnest at options to transition the economy to a post-pandemic environment, decisive tax reform and deregulation are paramount. This is a chance to set the country’s economic course for decades to come, as well as address how we begin repaying the mountainous debt. Despite the electorates’ rejection of Labor’s anti-franking agenda at the last election, tax reform could include changes to the franking regime. That is not particularly good news for income-dependent investors in retirement.

Remember, this is your superannuation fund, for your retirement, not an inheritance vehicle. They’ll probably get the house anyway! This is not being selfish. If you don’t look after yourself first, it is difficult to look after others. And a healthy retirement can at times be expensive.